Moats –a word that invokes images of castles, villages, and towns with large ditches around them filled with water or other defenses to keep invaders out. Archeologists found the earliest evidence of moats in the ruins of Babylon and relics from Egypt, Assyria, and others. Later, these moats became the first line of defense for castles, fortifications, villages, and more.
Considering moats are barriers, in business terms, an economic moat safeguards a company from its competitors. Warren Buffet coined the term economic moat in 1999 and popularised it. He often says, “In business, I look for economic castles protected by un-breachable moats.”
Investors often wonder what an economic moat means and if it can be a factor one considers to pick the right stocks. So, let us understand an economic moat, why it’s crucial, and how one can select companies to invest in.
Economic Moats of a Company
Any advantages or qualitative features that give a company a competitive edge, making it unique among its peers, are economic moats. It is often a qualitative measurement of its ability to keep its competitors away for long periods. Qualitative features can be hard to quantify as they don’t have an identifiable monetary value.
These moats can be anything from intangible assets, switching costs, low-cost provider advantages, and monopolistic positions to network-led growth, cultural differences, and superior technology. These advantages can help a company stand out among its peers.
For instance, the Tata Group is considered trustworthy, an intangible asset built over time. Other companies find it difficult to replicate such an edge. On the other hand, Shree Cement Limited has easy access to limestone reserves, and its customers are within 200 km of its manufacturing plant. The easy access offers Shree Cement locational benefits that other cement manufacturers may not have. Similarly, IRCTC is the only Indian Railways authorized entity for online train tickets giving it a monopolistic advantage over others in the travel industry.
Companies need Economic Moats
Companies must have economic moats, which help them grow quickly, earning high profits. A financial advantage allows companies to grow over the long term, gaining market share, and increasing profitability. Like the castle, moats protect those within the company and their earnings from competitors.
Moats are Important
Most value investors prefer undervalued shares of companies with wider moats. Investing in companies with economic moats helps to ensure one’s portfolio is optimally diversified. So, investors must look for businesses with economic moats for successful returns, as these moats add intrinsic value. Companies that can compound cash flow for many years are worth more, especially when one picks stocks for investments than a firm that cannot.
The higher the reinvestment opportunities a business has, the better the intrinsic value of its moats. However, the moats of a company with limited reinvestment opportunities add little inherent value.
Identifying the economic moats of a company
One of the simplest ways to identify economic moats in a company is getting answers to questions like —
- What are the company’s revenue sources?
- Which revenue source is a cash cow?
- Which industry does the company belong to?
- Who are the competitors?
- How is the company different from its competitors?
Another way to identify companies with an economic moat is to check if they have a stellar performance despite a slowdown in the economy or if their market share has increased consistently over the years. Look at the financial reports to know if sales and profit have grown consistently; the RoE and RoCE are positive. It’s sensible to check other aspects, such as the company’s market sentiment or search for businesses that are gaining popularity due to high-quality products and services that not many offer in the industry.
Companies with strong economic moats are often ahead of their competition. As a result, their revenue and profits increase over time. Their market capitalisation and size will also be better than the competitors.
However, not all traits are economic moats. For instance, good-quality products, substantial market share, great operational execution, and good management are not moats. However, these advantages do not guarantee long-term success. So, one must be aware and avoid falling for mistaken moats.
For example, any profitable company that is easy to compete with will decline over time. Similarly, any technological advantage another firm can easily replicate is not an economic moat. But an intangible advantage that another business cannot replicate or compete with, like a patented tech, will be an economic moat for the company.
So, should one have moated companies in their portfolio? Yes, having 10-15 moated companies that may compound at high rates in a portfolio will help one create sustainable wealth for the long term.